Fault Lines: How Hidden Fractures Still Threaten the World Economy (12 page)

Indeed, when an upstart haircutting firm in Japan recently started opening salons rapidly and undercutting existing barber shops by offering quick, cheap haircuts, a nationwide association of barbershops took note.
²²
It called for more regulation, protesting that it was unhygienic to cut hair without a shampoo beforehand, and had an ordinance passed requiring all barbershops to have expensive shampooing facilities. This immediately slowed the upstart and hit directly at its low-price strategy.

More generally, as rising wages in the productive export sector pulled up wages elsewhere in the economy, high wages (relative to productivity) and the resulting high prices of nontraded goods such as haircuts, restaurant meals, and hotel rooms reduced domestic demand for them. So the export-oriented miracle economies started looking oddly misshapen, much like someone who exercises only the limbs on one side of the body: a superefficient manufacturing sector existed side by side with a moribund services sector; a focus on foreign demand persisted even while domestic demand lay dormant.

Japan’s and Germany’s dependence on exports for growth did not matter much in the early years, when they were small relative to the rest of the world. But as they became the second and third largest economies in the world, it put a substantially greater burden on other countries to create excess demand.

What is particularly alarming for the future of countries following this path is that Japan did try to change, but without success. In the Plaza Accord of 1985, Japan agreed, under U.S. pressure, to allow its exchange rate to appreciate against the dollar. As Japanese exports came under pressure, the Bank of Japan cut interest rates sharply. According to a high-ranking Bank of Japan official: “We intended first to boost both the stock and property markets. Supported by this safety net—rising markets—export-oriented industries were supposed to reshape themselves so they could adapt to a domestically-led economy. This step then was supposed to bring about enormous growth of assets over every economic sector. This wealth-effect would in turn touch off personal consumption and residential investment, followed by an increase of investment in plant and equipment. In the end, loosened monetary policy would boost real economic growth.”
²³

What the loose monetary policy instead triggered was a massive stock market and real estate bubble that led to the widely circulated, although exaggerated, claim that the land on which the Imperial Palace stood in Tokyo was worth more than the state of California. Corporate investment did pick up. But instead of reorienting themselves toward manufacturing for domestic demand, Japanese firms started investing much more in East Asian countries where labor costs were substantially cheaper, again with the intent of exporting. Construction and consumption in Japan did boom, but these were temporary spikes. When the alarmed central bank started raising rates in the early 1990s, the collapse in stock and real estate prices led to an economic meltdown whose effects are still being felt.

So, far from automatically becoming more balanced in their growth as they become rich, export-led economies have found it extremely hard to boost their growth on their own, because the typical channels through which they can increase final consumption tend to atrophy during the period of emphasis on exports. As banks grow used to protected markets and instructions on whom to lend to, they have little capacity to lend carefully when given the freedom to do so. Also, given the strong ties between the government and producers, it is far more convenient for the government to channel spending through domestic producers that are influential but not necessarily efficient. In Japan, more government spending generally results in more bridges and roads to nowhere as the powerful construction lobby secures stimulus funds. Even as Japan has been covered with stimulus-induced concrete, the economy has remained moribund.

As a result, not only are countries like Japan unable to help the global economy recover from a slump, but they are themselves dependent on outside stimulus to pull them out of it. This is a serious fault line. Indeed, an important source of Japan’s malaise in the early 1990s was that the United States did not pull out all the customary stops in combating the 1990–91 U.S. recession, and thus did not provide the demand that historically had helped Japan out of its downturns. It was not until the early 2000s, after a number of failed Japanese attempts to pull itself out of its decade-long slump, that the massive U.S. stimulus in response to the dot-com bust helped Japan export its way out of trouble yet again.
²⁴

There is no natural, smooth, and painless movement away from export dependence to becoming a balanced economy. Even ignoring the clout of the export sector, which would like to preserve its benefits, the costs of changing emphasis are substantial, and the tools the government has for redressing past distortions are limited. For instance, wages in the domestic sector are often too high relative to productivity in those sectors. To allow greater differentiation of wages, as will be necessary to allow the service sector to flourish, existing service-sector workers must suffer a steep drop in incomes. They have strong incentives to fight against such change. Moreover, foreign entry into the service sector could boost productivity. But years of protection and overregulation are hard to overcome, and strong incumbent interests, like those of the Japanese barbers, will fight against competition and entry.

Similarly, consumers have been trained to be cautious about spending, and retail finance is not well developed. Japanese households, unlike those in the United States, do not readily borrow to spend. It is hard for older people to forget the experiences of postwar deprivation and insecurity or the subsequent period of growth when saving was considered patriotic, and it is the older generations who have more spending power and still determine the overall pattern of consumption. For a while, younger consumers in Japan were thought to offer the answer. But after years of depressing economic outcomes, they too seem to be retreating into their shells, perhaps further depressed by the enormous public debt and underfunded pension schemes they will have to shoulder.
²⁵
Economic reform in Japan requires tremendous political will, a commodity in short supply when the status quo is perfectly comfortable and the pace of relative decline gentle.

Will the world become more balanced in the future as the late developers continue to grow? The experiences of Germany and Japan offer grim portents for the future. A number of late developers will be joining the ranks of the middle-income nations, if not the rich, in the near future. Will they continue to depend excessively on exports, or will they be able to reform their economies, making the needed transformation back to balanced growth, once they have become rich? Of especial importance is China, which barring untoward incidents, is likely to become the world’s largest economy in a decade or two. Although China has a huge domestic economy, it too has followed the path of export-led growth.

Chinese households consume even less as a share of the country’s income than the typical low average in export-oriented economies. Because economic data from China, as in many developing countries, are not entirely reliable, economists constantly attribute any Chinese aberration to data problems. But assuming the data are broadly right, why is Chinese household consumption so extraordinarily low? In part, it is because Chinese households cannot rely on the traditional old-age safety net in Asia, namely children. As a result of the government’s policy of allowing most couples only one child, six adults (four grandparents and two parents) now depend on one child for future support.
²⁶
No wonder adults, especially older ones, are attempting to increase their savings quickly. To make matters worse, many of them have lost the cradle-to-grave benefits that once came with jobs with state-owned firms, and the costs of needed services like health care are rising quickly as the economy develops. China is trying to improve its pension and social security system, but countries typically take decades to convince citizens that they will get what is promised from such schemes.

China also faces a more traditional problem related to export-led growth strategies. As a proportion of the total income generated in the Chinese economy, household incomes are low. Wages are low because they are held down by the large supply of workers still trying to move from agriculture to industry. Household income is further limited because the subsidized inputs to state-owned firms, like low interest rates, also mean households receive low rates on their bank deposits. Moreover, a number of benefits such as education and health care are no longer provided for free by the state, eating further into discretionary spending.

Finally, consumption may be low because Chinese households feel poorer than they actually are. State-owned firms do not pay dividends to the state and because households do not own their shares directly, they do not see the extremely high profits made at state-owned firms as part of their own wealth. Of course, in the long run, it is hard to believe that the wealth created by these state-owned firms will not be recaptured for the public good. For now, though, households believe they have no part in it, and they consume less than they might if they believed they were richer.

Low domestic consumption, of course, makes the economy excessively reliant on foreign demand. Moreover, even if the Chinese can find ways to boost household consumption in a crisis, it constitutes only a small share of overall demand, and thus the effect on growth is small. Therefore, the Chinese authorities typically try to stimulate investment when they need to keep up growth in the face of a global slowdown—and they do need strong growth to keep up with the expectations of the people. They push loans from the state-owned banking system to local governments and state-owned firms, who then do more of what they were already doing, without regard to long-run profitability. Thus far China has successfully followed the principle “Build it and they will come.” But rapid investment in fixed assets carries many dangers, especially once the basic infrastructure is in place. As Yasheng Huang of MIT points out, Chinese bureaucrats have a penchant for glamour projects—vast airports, fancy modern buildings (typically housing the bureaucrats themselves), and enormous malls. It is not clear that this way of stimulating the economy will remain sustainable. China’s leadership has adapted in the past when necessary. Can they step away from the seductions of export-led growth and fixed-asset investment before it is too late? Only time will tell whether China will deepen or mend this fault line.

The late developers were not innovators initially: they had no need to innovate because rich countries had already developed the necessary technology, and the technology could be licensed or “borrowed.” Instead, they tried to remedy a fundamental deficiency: the weakness of existing organizations—even while tackling more traditional development problems like the lack of basic education and skills in the workforce and deficiencies in the health care system. The process of strengthening organizations, in their view, required massive but careful government intervention. Infant firms had to be nurtured. The very real danger, as evidenced in India’s stagnation during the 1960s and 1970s, was that the infant firms would demand permanent protection and then strangle growth.

One option was to increase internal competition by reducing barriers to entry and eliminating various subsidies. But governments thought this would waste resources and be potentially harmful to the incumbents who had only recently become profitable. Moreover, the internal market was small, made even smaller by the repression of households in favor of producers. The solution instead was to use the disciplinary power, as well as the attractiveness, of the large global market. Governments forced the now-healthy firms to compete to export, using the threat of opening up the economy to foreign investment to keep firms on their toes.

There were considerable pressures on the government to prevent it from forcing this change. Businesses would have loved protection to continue so that they could lead a quiet, profitable, life. But a few governments, typically authoritarian ones that managed to avoid the influence from the private sector that comes with having to fight elections, drove the transformation to an export orientation.
²⁷
Those are the growth miracles that we celebrate today.

Unfortunately, their growth is still strongly dependent on exports. Government policies, domestic vested interests, and household habits formed during the years of catch-up growth conspire to keep them dependent. The world has thus become imbalanced in a way that markets cannot fix easily: much of my tenure at the International Monetary Fund was spent warning not about finance but about global trade imbalances. The two are linked, for the global trade surpluses produced by the exporters search out countries with weak policies that are disposed to spend but also have the credibility to borrow to finance the spending—at least for a while. In the 1990s, developing countries, especially those in Latin America and East Asia, spent their way into distress. How and why this happened is what I turn to next.

I
N THE 1980S AND 1990S
, surpluses produced by exporters like Germany and Japan were looking for markets.
¹
Poorer developing countries, with low levels of per capita consumption and investment, were ideal candidates for boosting their spending, provided they could get financing. In fact, even though they too focused on producing for export markets, a number of developing countries, like Korea, invested a lot as they grew, importing substantial quantities of raw material, capital goods, and machinery. In doing so, they ran large trade deficits and helped absorb the surpluses.